CLSA says financial sector is in phase 2 of the credit and deposit growth cycle during which banks will underperform; banks with a stronger current and saving accounts ratio, balanced asset liability management and lower dependence on wholesale deposits are better positioned; it prefers ICICI, HDFC Bank, PNB, SBI

Since March 2010, credit growth has been running ahead of deposit growth creating tight liquidity conditions. Credit growth is at 23%, but deposit growth has lagged behind at just 16%. Also, since January 2010 the cash reserve ratio is up 100bps (it has been hiked six times this year) to 6% of liabilities. Bank borrowing from the Reserve Bank of India’s repo window is now a high 3% of the deposits or Rs1.2 trillion. The incremental loan-to-deposit ratio has increased to 100% (from less than 70% in April).

All this has forced most banks to hike their deposit rates by as much as 150 basis points. Since short-term interest rates have moved up faster than the long-term rates (incidentally, leading to a flattening of the yield curve), short-term deposit rates have gone up more than the long-term rates on deposits. Since lending rate hikes have been slower and lower than the deposit rate hikes, banks’ margins are going to be under pressure from here on.

CLSA’s analysis of the interest rate cycle over the past six years indicates that high loan-to-deposit ratios lead to deposit rates rising ahead of and faster than lending rates. “In the last cycle margins contracted, especially for low CASA banks, as banks were not able to pass on the higher cost of deposits,” it says in a report to its clients.

In this scenario, it believes that “banks with a stronger CASA franchise, balanced ALM (asset liability management) and lower dependence on wholesale deposits are better positioned.” It recommends HDFC Bank and ICICI among private banks and State Bank of India (SBI) and Punjab National Bank (PNB) among the public sector banks. Axis has a high CASA ratio, but may face margin pressures due to some ALM gap and a higher share of wholesale deposits.

CLSA believes that the financial sector is in phase 2 of the cycle of credit and deposit growth, where deposit rate rise is greater than the lending rate hike, credit growth remains healthy, deposit growth picks up, incremental LDR moderates but spreads and margins contract leading to banks' underperforming. This phase lasted a year last time from January 2006 to December 2006, a figure in its report shows. Phase 2, according to CLSA will be lending rate rising faster than deposit rates, continuation of healthy credit growth, healthy deposit growth, incremental LDR stabilises, leading to spreads and margins expanding and outperformance of bank stocks. In the last cycle this phase lasted between January 2007 and December 2007.

Phase 1, which we have just come out of, according to CLSA, lasted from July 2009 to now, and previously between June 2004 and December 2005. In this phase, interest rates were low, leading to a pick-up in credit growth even when deposit growth remained low and incremental LDR rose. Spreads and margins expanded leading to bank stocks outperforming.

Among banks that CLSA covers, HDFC Bank has the highest CASA ratio at 50%+, followed by SBI and ICICI at a little less than 50%, Axis and PNB at a little above 40%, Bank of Baroda (BoB) and Bank of India (BoI) at between 30% and 40%, and Corporation Bank, Oriental Bank of Commerce and Canara Bank between 20% and 30%. In terms of CASA growth, Axis, HDFC Bank, SBI, BoB, and Union Bank score the highest. Yes Bank, Axis and ICICI have the highest dependence on wholesale deposits while SBI, Union Bank and PNB have the lowest.

(This article is based on secondary research. The report is for information only. None of the stock information, data and company information presented herein constitutes a recommendation or solicitation of any offer to buy or sell any securities. Investors must do their own research and due diligence before acting on any security. Some of the opinions expressed in this article are the author’s own and may not necessarily represent those of Moneylife.)